Answer No.

1
(a)Liquidity Decisions
Current assets management that affects a firms liquidity is yet another
important finances function, in addition to the management of long-term
assets. Current assets should be managed efficiently for safeguarding the
firm against the dangers of illiquidity and insolvency. Investment in current
assets affects the firms profitability. Liquidity and risk. A conflict exists
between profitability and liquidity while managing current assets. If the firm
does not invest sufficient funds in current assets, it may become illiquid. But
it would lose profitability, as idle current assets would not earn anything.
Thus, a proper trade-off must be achieved between profitability and liquidity.
In order to ensure that neither insufficient nor unnecessary funds are
invested in current assets, the financial manager should develop sound
techniques of managing current assets. He or she should estimate firms
needs for current assets and make sure that funds would be made available
when needed. It would thus be clear that financial decisions directly concern
the firms decision to acquire or dispose off assets and require commitment
or recommitment of funds on a continuous basis. It is in this context that
finance functions are said to influence production, marketing and other
functions of the firm. This, in consequence, finance functions may affect the
size, growth, profitability and risk of the firm, and ultimately, the value of the
firm. To quote Ezra Solomon the function of financial management is to
review and control decisions to commit or recommit funds to new or ongoing
uses. Thus, in addition to raising funds, financial management is directly
concerned with production, marketing and other functions, within an
enterprise whenever decisions are about the acquisition or distribution of
assets. Various financial functions are intimately connected with each other.
For instance, decision pertaining to the proportion in which fixed assets and

current assets are mixed determines the risk complexion of the firm. Costs of
various methods of financing are affected by this risk. Likewise, dividend
decisions influence financing decisions and are themselves influenced by
investment decisions. In view of this, finance manager is expected to call
upon the expertise of other functional managers of the firm particularly in
regard to investment of funds. Decisions pertaining to kinds of fixed assets to
be acquired for the firm, level of inventories to be kept in hand, type of
customers to be granted credit facilities, terms of credit should be made
after consulting production and marketing executives. However, in the
management of income finance manager has to act on his own. The
determination of dividend policies is almost exclusively a finance function. A
finance manager has a final say in decisions on dividends than in asset
management decisions. Financial management is looked on as cutting across
functional even disciplinary boundaries. It is in such an environment that
finances manager works as a part of total management. In principle, a
finance manager is held responsible to handle all such problem: that involve
money matters. But in actual practice, as noted above, he has to call on the
expertise of those in other functional areas to discharge his responsibilities
effectively.

(b) Dividend Decisions

Dividend decision refers to the policy that the management formulates in
regard

to

earnings

for

distribution

as

dividends

among

shareholders. Dividend decision determines the division of earnings

between payments to shareholders and retained earnings.
The Dividend Decision, in corporate finance, is a decision made by the
directors of a company about the amount and timing of any cash payments
made to the company's stockholders. The

Dividend

important part of the present day corporate world.

Decision is an

The Dividend decision is an important one for the firm as it may influence
its capital structure and stock price. In addition, the Dividend decision may
determine the amount of taxation that stockholders pay.
Factors influencing Dividend Decisions
There are certain issues that are taken into account by the directors while
making the dividend decisions:

Free Cash Flow

Signaling of Information

Clients of Dividends
Free Cash Flow Theory
The free cash flow theory is one of the prime factors of consideration when
a dividend decision is taken. As per this theory the companies provide the
shareholders with the money that is left after investing in all the projects that
have

positive

net

present

value.

Signaling of Information
It has been observed that the increase of the worth of stocks in the share
market is directly proportional to the dividend information that is available in
the market about the company. Whenever a company announces that it
would provide more dividends to its shareholders, the price of the shares
increases.
Clients of Dividends
While taking dividend decisions the directors have to be aware of the
needs of the various types of shareholders as a particular type of distribution
of shares may not be suitable for a certain group of shareholders.

It has been seen that the companies have been making decent profits and
also reduced their expenditure by providing dividends to only a particular
group

of

shareholders.

Factors influencing the dividend decision

Liquidity of funds

Stability of earnings

Financing policy of the firm

Dividend policy of competitive firms

Past dividend rates

Debt obligation

Ability to borrow

Growth needs of the company

Profit rates

Legal requirements

Policy of control

Corporate taxation policy

Tax position of shareholders

Effect of trade policy

Attitude of the investor group

Leverage

Answer No. 2
(a) Doubling Period
Doubling period is the period which makes the investment as "Doubled", that
is the amount invested fetches 100% return.

There are two different approaches Viz.

1. Rule of 72
2. Rule of 69
1. Rule of 72
The initial amount of investment gets Doubled within which 72/I
Where, I = Interest Rate of the investment.
For example
The amount of the investment is Rs.1,00,000. The annual rate of interest is
12%.
Then the doubling period of Rs.1,00,000 is 72/12 = 6 years
2. Rule of 69
The amount method is found to crude logic in determining the doubling
period which has its own limitations. The rule of 69 eliminates the bottleneck
associated with the rule of 72 methods.
The rule of 69 is originate to be a scientific and rational method in
determining the doubling period of the investment made
As per rule of 69 method the doubling period is calculated as 0.35+ 69/I
For example
The amount of the investment is Rs.1 00,000. The annual rate of interest is
12%.
Then the doubling period of Rs.1,00,000 is 0.35+ 69/12= 6.1 yrs

(b) Numerical

Total Amount = Principal + CI (Compound Interest)

Formulae for Interest Compounded Quarterly
Total Amount = A = P(1 + r/n)nt
=1000{ 1 + (10 /4) 42
=1218.4

(c) Present Value

The current worth of a future sum of money or stream of cash flows given a
pacified rate of Return. Future cash flows are discounted at the discount rate,
and the higher the discount rate, the lower the present value of the future
cash flows. Determining the appropriate discount rate is the key to properly
valuing future cash flows, whether they be earnings or obligations.
This sounds a bit confusing, but it really isn't. The basis is that receiving
1000 now is worth more than 1000 five years from now, because if you got
the money now, you could invest it and receive an additional return over the
five years.
The calculation of discounted or present value is extremely important in
many financial calculations. For example, net present value, bond yields,
spot rates, and pension obligations all rely on the principle of discounted or
present value. Learning how to use a financial calculator to make present
value calculations can help you decide whether you should accept a cash
rebate, 0% financing on the purchase of a car or to pay points on a
mortgage.

Answer No. 3

1)Operating Leverage : It is defined as the "firm's ability to use fixed

operating costs to magnify effects of changes in sales on its EBIT ". When
there is an incr ease or decrease in sales level the EBIT also changes. The
effect of changes in sales on the level EBIT is measured by operating
leverage.
Operating leverage = % Change in EBIT / % Change in sales
= [Increase in EBIT/EBIT] / [Increase in sales/sales]
Significance of operating leverage: Analysis of operating leverage of a firm is
useful to the financial manager. It tells the impact of changes in sales on
operating income. A firm having higher D.O.L. (Degree of Operating Lever
age) can experience a magnified effect on EBIT for even a small change in
sales level. Higher D.O.L. can dramatically increase operating profits. But, in
case of decline in sales level, EBIT may be wiped out and a loss may be
operated. As operating leverage, depends on fixed costs, if they are high, the
firm's operating risk and leverage would be high. If
Operating leverage is high, it automatically means that the break -even point
would also be reached at a high level of sales. Also, in case of high operat ing
leverage, the margin of safety would be low. Thus, it is preferred to operate
sufficiently above the break -even point to avoid the danger of fluctuations in
sales and profits.
2) Financial Leverage :
It is defined as the ability of a firm to use fixe d financial charges to magnify
the effects of changes in EBIT/Operating profits, on the firm's earnings per
share. The financial leverage occurs when a firm's capital structure contains

obligation of fixed charges e.g. interest on debentures, dividend on

preference shares, etc. along with owner's equity to enhance earnings of
equity shareholders. The fixed financial charges do not vary with the
operating profits or EBIT. They are fixed and are to be repaid irrespective of
level of operating profits or EBIT . The ordinary shareholders of a firm are
entitled to residual income i.e. earnings after fixed financial charges. Thus,
the effect of changes in operating profit or EBIT on the level of EPS is
measured by financial leverage.
Financial leverage = % change in EPS/% change in EBIT or
= (Increase in EPS/EPS)/{Increase in EBIT/EBIT}
The financial leverage is favorable when the firm earns more on the
investment/assets financed by sources having fixed charges. It is obvious
that shareholders gain a situation where the company earns a high rate of
return and pays a lower rate of return to the supplier of long term funds, in
such cases it is called 'trading on equity'. The financial leverage at the levels
of EBIT is called degree of financial leverage and is calculated as ratio of EBIT
to profit before tax.
Degree of financial leverage = EBIT/Profit before tax
Shareholders gain in a situation where a company has a high rate of return
and pays a lower rate of interest to the suppliers of long term funds. The
difference accrues to the shareholders. However, where rate of return on
investment falls below the rate of interest, the shareholders suffer, as their
earnings fall more sharply than the fall in the return on investment.
Financial leverage helps the finance manager in designing the appropriate
capital structure. One of the objective of planning an appropriate capital
structure is to maximize return on equity shareholders' funds or maximize
EPS. Financial leverage is double edged s word i.e. it increases EPS on one

hand, and financial risk on the other. A high financial leverage means high
fixed costs and high financial risk i.e. as the debt component in capital
structure increases, the financial risk also increases i.e. risk of insolvency
increases. The finance manager thus, is required to trade off i.e. to bring a
balance between risk and return for determining the appropriate amount of
debt in the capital structure of a firm. Thus, analysis of financial leverage is
an important too l in the hands of the finance manager who are engaged in
financing the capital structure of business firms, keeping in view the
objectives of their firm.

3) Combined leverage:
Combined Leverage = Operating leverage * Financial leverage
= (% change in EBIT/% change in sales) * (% change in EPS/% change in
EBIT)
= % change in EPS/% change in sales
The ratio of contribution to earnings before tax, is given by a combined effect
of financial and operating leverage. A high operating and high financial
leverage is very risky, even a small fall in sales would affect tremendous fall
in EPS. A company must thus, maintain a proper balance between these 2
leverage. A high operating and low financial leverage indicates that the
management is careful as higher amount of risk involved in high operating
leverage is balanced by low financial leverage. But, a more preferable
situation is to have a low operating and a high financial leverage. A low
operating leverage automatically implies that the company reaches its break
-even point at a low level of sales, thus, risk is diminished. A highly cautious

and conservative manager would keep both its operating and financial
leverage at very low levels. The approach may, mean that the company is
losing profitable opportunities.

Answer No. 4
(a)

Factors Affecting capital structure

(1) Cash Flow Position:

While making a choice of the capital structure the future cash flow position
should be kept in mind. Debt capital should be used only if the cash flow
position is really good because a lot of cash is needed in order to make
payment of interest and refund of capital.
(2) Interest Coverage Ratio-ICR:
With the help of this ratio an effort is made to find out how many times the
EBIT is available to the payment of interest. The capacity of the company to
use debt capital will be in direct proportion to this ratio.
It is possible that in spite of better ICR the cash flow position of the company
may be weak. Therefore, this ratio is not a proper or appropriate measure of
the capacity of the company to pay interest. It is equally important to take
into consideration the cash flow position.
(3) Debt Service Coverage Ratio-DSCR:
This ratio removes the weakness of ICR. This shows the cash flow position of
the company.
This ratio tells us about the cash payments to be made (e.g., preference
dividend, interest and debt capital repayment) and the amount of cash
available. Better ratio means the better capacity of the company for debt
payment. Consequently, more debt can be utilized in the capital structure.
(4) Return on Investment-ROI:
The greater return on investment of a company increases its capacity to
utilize more debt capital.
(5) Cost of Debt:

The capacity of a company to take debt depends on the cost of debt. In case
the rate of interest on the debt capital is less, more debt capital can be
utilized and vice versa.
(6) Tax Rate:
The rate of tax affects the cost of debt. If the rate of tax is high, the cost of
debt decreases. The reason is the deduction of interest on the debt capital
from the profits considering it a part of expenses and a saving in taxes.
For example, suppose a company takes a loan of 0ppp 100 and the rate of
interest on this debt is 10% and the rate of tax is 30%. By deducting 10/from the EBIT a saving of in tax will take place (If 10 on account of interest
are not deducted, a tax of @ 30% shall have to be paid).
(7) Cost of Equity Capital:
Cost of equity capital (it means the expectations of the equity shareholders
from the company) is affected by the use of debt capital. If the debt capital is
utilized more, it will increase the cost of the equity capital. The simple reason
for this is that the greater use of debt capital increases the risk of the equity
shareholders.
Therefore, the use of the debt capital can be made only to a limited level. If
even after this level the debt capital is used further, the cost of equity capital
starts increasing rapidly. It adversely affects the market value of the shares.
This is not a good situation. Efforts should be made to avoid it.

(b)Numerical
Firm A

Firm B
Weight

Equity

ed
share 1

K
15%

W*K

Weighte

W*K

15%

d
.67

15%

10.05%

Capital
Debt 10%
Total Cost

10%

15%

.33

10%

Answer No. 5
(a)Numerical
(i) Net Present Value (NPV Using risk free rate)
Year

Cash Inflow

Present Value Net

Factor

cash

Inflow
Cash

140,000
250,000
315,000
4
30,000
Total
Total PV of Cash Inflows

inflow*PVF
0.9090
36,360
0.8264
41,320
07513
11,269
0.6849
20,547
1,09496.5
109,496.5 Initial Investment -100,000

Net Present Value (NPV Using risk free rate) 9,496.5 thousand

(ii) NPV using risk-adjusted discount rate

Risk-adjusted discount rate = Risk free rate + Risk premium
Risk premium = 9496.5*10%
=949.65
Then risk adjusted discount rate = 9496.5+949.65

3.3%
13.35%

= 10446.15

(b)

Risk In capital Budgeting

Like anything, projects do have risks. There are three types of project risks
associated with capital budgeting:
1. Stand-Alone Risk
This risk assumes the project a company intends to pursue is a single asset
that is separate from the company's other assets. It is measured by the
variability of the single project alone. Stand-alone risk does not take into
account how the risk
of a single asset will affect the overall corporate risk.
2. Corporate Risk
This risk assumes the project a company intends to pursue is not a single
asset but incorporated with a company's other assets. As such, the risk of a
project could be diversified away by the company's other assets. It is
measured by the potential impact a project may have on the company's
earnings.
3. Market Risk
This looks at the risk of a project through the eyes of the stockholder. It looks
at the project not only from a company's perspective, but from the
stockholder's overall portfolio. It is measured by the effect the project may
have on the company's beta.

Answer No. 6
(a)

Objectives of cash management

In order to ensure you meet the objectives of an effective cash management

policy, the financial manager must ensure that the company meets the
payment schedule and also minimize idle funds committed to cash balances.
Meeting Cash Balances
The financial manager must ensure he has enough cash in hand to pay
suppliers, creditors, employees, shareholders, banks, etc
Most financial managers at times go a step further and keep even more than
required. This can be the result of various factors such as:

Enhancing the companys reputation settling payments on time

keeps creditors and suppliers happy

Taking advantage of trade discounts by paying your debts on time

Stronger negotiating power when dealing with suppliers

Unexpected cash requirements can be met with no problem at all

Minimizing idle balances

Too much cash tied up in idle balances waiting for something to happen
involves an opportunity cost and hence loss of profits. As you minimize the
cash balance, you increase the chance of a shortfall and of failing to meet
your payments schedule. A company must always try to find a suitable cash
management policy and this at times can be facilitated by having a cash
budget in place. By doing so, a company could forecast its cash inflows and
outflows for the coming period and thus estimate with reasonable precision
the amount of cash balance that it must keep idle.

As a compromise, many companies try to hold some of their cash in shortterm investments such as Deposit/Savings Accounts and Fixed Term Deposits
Accounts. Government Securities are also attractive for those opting for
marketable securities.
Cash is one of the most important aspects of a business. Lack of cash could
and would probably lead to financial problems hence it is vital for a company
to have a financial manager who is responsible for managing its cash to
ensure it has enough to pay off creditors whilst also making profit from
possible investment schemes with its idle cash.

(b)

Baumol Model of Cash Management

Baumol model of cash management helps in determining a firm's optimum

cash balance under certainty. It is extensively used and highly useful for the
purpose of cash management. As per the model, cash and inventory
management

problems

are

one

and

the

same.

William J. Baumol developed a model (The transactions Demand for Cash: An

Inventory

Theoretic

management

Approach)
&

which

is

usually

cash

used

in

Inventory

management.

Baumol model of cash management trades off between opportunity cost or

carrying cost or holding cost & the transaction cost. As such firm attempts to
minimize the sum of the holding cash & the cost of converting marketable
securities to cash.
Relevance
At present many companies make an effort to reduce the costs incurred by
owning cash. They also strive to spend less money on changing marketable
securities to cash. The Baumol model of cash management is useful in this
regard.
Assumptions
There are certain assumptions or ideas that are critical with respect to the

Baumol

model

of

cash

management:

The particular company should be able to change the securities that

they own into cash, keeping the cost of transaction the same. Under normal
circumstances, all such deals have variable costs and fixed costs.

The company is capable of predicting its cash necessities. They should

be able to do this with a level of certainty. The company should also get a
fixed amount of money. They should be getting this money at regular
intervals.

The company is aware of the opportunity cost required for holding

cash. It should stay the same for a considerable length of time.

The company should be making its cash payments at a consistent rate

over a certain period of time. In other words, the rate of cash outflow should
be regular.

Equational

Representations

in

Holding Cost = k(C/2)

Transaction Cost = c(T/C)

Total Cost = k(C/2) + c(T/C)

Baumol

Model

of

Cash

Management:

Where T is the total fund requirement, C is the cash balance, k is the

opportunity

cost

&

is

the

cost

per

Limitations of the Baumol model:

1. It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.

transaction.